Question

1. Carolyn Fulton, the CFO of Nuts and Bolts Inc. is considering a proposed project to launch an on-line catalog that would allow customers to by-pass the retail store and have items delivered directly to their homes.

Nuts and Bolts Retail got its start as modest Do-it-yourself (DIY) supply store in 1985. It grew from one store, in Charlotte, North Carolina, to over 1000 stores nationwide with revenues over

$20 billion and net profit over $250 million.  The explosive growth began to slow in the late

1990s, but the firm has remained profitable.  To re-ignite revenue growth, management is currently evaluating an on-line sales channel. Studies done by the firm’s marketing department indicate that a large component of the customer base are buying DIY products on-line from other sources, or would like to buy DIY products if available from a reliable retailer.

The design and the development of the web infrastructure would cost an estimated $10 million at time 0 and an additional $10 million at time 1 to acquire and integrate the hardware and software (these are capital expenditures).  Estimated depreciation for the equipment is included below. Start-up expenses would be $2 million plus an investment in inventory of $10 million. The entire net working capital investment will be an additional $5 million in year 1, and the NWC balance would then grow by 15% each year in years 2 through 5. All NWC will be recovered at the end of the project. The on-line catalog is expected to generate new sales of $100 million in the first year and then sales would grow by 15% per year. However the marketing department estimated that the on-line sales would cut into sales at the existing retail stores by as much as $15 million in the first year and this cannibalization would grow by 15% each year in years 2 through 5. Additionally the company would have to hire additional staff to manage the website and shipping logistics, and incur additional cost to configure warehouse operations to efficiently process on-line orders. Operating margins excluding depreciation (the EBITDA margin) on the on-line sales were expected to be the same as retail sales: 8% for the first two years, then 10% thereafter. After 5 years it is expected that the technology will become obsolete and it will have no residual value.

Carolyn wants to determine whether or not to proceed. When analyzing an investment of this risk, the firm assumes a hurdle rate (cost of capital) of 10%.  Assume the effective tax rate is 40%.

EstimatedDepreciationExpense(000’s)

Year
0	$2,000
1	$5,200
2	$5,120
3	$3,072
4	$2,304
5	$2,304

What is the Net Present Value of the proposed project?

Answer 1

Calculation of Net Present value
in millions $	Year
Particulars	0	1	2	3	4	5	Total
Design and development cost of web infrastructure	(10.0)	(10.0)	-	-	-	-	(20.0)
Investment in working capital	(12.0)	(5.0)	(2.6)	(2.9)	(3.4)	25.9	-
Cash flow from online operations	-	8.9	8.9	7.6	8.2	9.3	42.9
Loss of Cash flow from retail operations	-	(0.9)	(1.0)	(1.0)	(1.1)	(1.3)	(5.2)
Total cash flow	(22.0)	(7.0)	5.4	3.7	3.8	33.9	17.7
Present value factor @ 10%	1.00	0.91	0.83	0.75	0.68	0.62
Present value of cash flow	(22.0)	(6.4)	4.4	2.8	2.6	21.1	2.4
Hence NPV of the project is $ 2.4 millions
Cash flow from online operations
in millions $	Year
Particulars	0	1	2	3	4	5	Total
Revenue	-	100.0	115.0	132.3	152.1	174.9	674.2
EBITDA margin (10% in first two years and 8% thereafter)	-	10.0	11.5	10.58	12.17	13.99	58.2
Depreciation expense	(2.0)	(5.2)	(5.1)	(3.1)	(2.3)	(2.3)	(20.0)
EBT	(2.0)	4.8	6.4	7.5	9.9	11.7	38.2
Less: Tax @ 40%	-	(1.9)	(2.6)	(3.0)	(3.9)	(4.7)	(16.1)
Add: Tax saving on loss in Year 0	-	0.8	-	-	-	-	-
EAT	(2.0)	3.7	3.8	4.5	5.9	7.0	22.9
Add: Depreciation	2.0	5.2	5.1	3.1	2.3	2.3	20.0
Cash flow from online operations	-	8.9	8.9	7.6	8.2	9.3	42.9
Loss of Cash flow from retail operations
in millions $	Year
Particulars		1	2	3	4	5	Total
Loss of revenue		(15.0)	(17.3)	(19.8)	(22.8)	(26.2)	(101.1)
Loss of EBITDA margin (10% in first two years and 8% thereafter)		(1.5)	(1.7)	(1.59)	(1.83)	(2.10)	(8.7)
Add: Tax saving @ 40%		0.6	0.7	0.6	0.7	0.8	3.5
Loss of Cash flow from retail operations		(0.9)	(1.0)	(1.0)	(1.1)	(1.3)	(5.2)